Constructive sales treatment for appreciated financial positions.

• Author: Palley, Jeffrey

Generally, a taxpayer does not recognize gain on a transaction until the transaction is closed. If a taxpayer owns a security (a long position), he is able to lock in the economic gain by "selling short against the box" (selling a borrowed security), or vice versa. Economically, the taxpayer is not affected by the valuation of the security; the values of his long and short positions move in exactly opposite directions.

Similar strategies have been executed with offsetting notional principal contracts, futures contracts, forward contracts and equity swaps on the same or similar securities. The IRS has repeatedly tried to tax the gain position, by treating it as a closed transaction when the risk of loss was eliminated. Regardless of the fact that the economic gain was already determined, the Service has lost its battles in the courts, and taxpayers were able to defer gain.

If a taxpayer died with these short-sale-against-the-box positions (i.e., the taxpayer owned securities that were the same as, or substantially identical to, the securities borrowed and sold short), the gain would escape taxation. Both the long position and the short position would be stepped up to fair market value (FMV) at death and the boxed gains would disappear.

These tax deferral schemes were virtually eliminated by the constructive sales provisions of the Taxpayer Relief Act of 1997. Currently, a constructive sale of an appreciated financial position will trigger gain as if such position were sold, assigned or otherwise terminated at its FMV as of the constructive sale date. The appreciated position would be treated as repurchased for its FMV on the constructive sale date.

The term "appreciated financial position" means any position for any stock, debt instrument or partnership interest if there would be gain were such position sold, assigned or otherwise terminated at its FMV. Exceptions are made for any position marked to market and also for any debt instrument, if three conditions are satisfied:

1. The debt unconditionally entitles the holder to receive a specified principal amount;

2. Interest payments are payable based on a fixed rate or, to the extent provided in regulations, on a variable rate; and

3. The debt is not convertible into stock of the issuer or any related person.

   A taxpayer is treated as having made a constructive sale of an appreciated financial position if he (or a related person):

1. Enters into a short sale of the same or substantially identical...